ESAs' report on voluntary disclosure of PAIs

Under SFDR, the ESAs are required, on an annual basis, to report to the Commission on best practice and make recommendations with respect to PAI disclosures. The Report is the 2023 iteration of that exercise. One of the proposals that the ESAs make in the Report is that the reporting cycle is amended from once a year to once every three years (please see further below).

Entity-level voluntary PAI disclosures and the reasons why some firms have elected to not consider the PAIs of investment decisions on sustainability factors (though a limited number of the ESAs' observations relate to product-level PAI disclosures).

No.

However, it does make a number of noteworthy observations about the current entity-level voluntary disclosures and what the ESAs and NCAs consider good and bad practice for complying with SFDR, notably in the context of the Commission's so-called fundamental review of SFDR (or "SFDR II") – see our briefing.

The Report contains a table of "dos and don'ts", mostly focussed on entity-level disclosures (see page 9 of the Report). Some of the key takeaways highlighted by the ESAs are not new.  PAI disclosures must be clear, identify indicators together with the methodology and data used for assessing each PAI, specify the reference period, include (where applicable) summaries of engagement policies and adherence to codes and internationally recognised standards, and be easily accessible on a navigable website.

Certain other key observations are set out below:

• Additional work required – "opt out" statements. Where financial market participants (FMPs) choose not to consider principal adverse impacts of investment decisions on sustainability factors on an entity-level, they are required under Article 4(1)(b) of SFDR to provide clear reasons for not doing so, including, where relevant, information as to whether and when they intend to consider such impacts. The ESAs found that the extent of the disclosures remains limited and made the following observations:

• • Include a target date for considering PAI indicators.  The ESAs noted that, at a minimum, it would be best practice for FMPs to include a date by which they will consider PAIs. Unless the "500-employee test" in Article 4(3) of SFDR is triggered, this is not required – FMPs can elect whether or not to consider PAIs.  Information on when they intend to do so is to be included where relevant. The Report does not change the law.  Firms should think carefully about this observation and take care not to over promise and under deliver.
    
    
  • Issues with data availability and comparability.  The Report notes that some explanations remain short and vague and, in their view, are insufficient justifications for opting out of considering PAIs.
     
  • Lack of legal clarity as the basis for opting out.  The ESAs suggest that it is no longer credible to state that legal uncertainty alone is a reason for opting out of considering PAIs.
    
    
  • Falling below the 500-employee threshold.  FMPs who satisfy the "500-employee" test in Article 4(3) SFDR are required to consider PAIs.  Many FMPs do not meet this threshold and may elect whether or not to opt into the regime.  The ESAs note that falling below the 500-employee threshold is not, in itself, a justification for choosing to opt out and some firms are inappropriately using it as such.

• Group disclosures. FMPs considering and disclosing PAIs at group level only and not on a solo basis represents bad practice.
  
  
• Alignment with the Paris Agreement remains vague. Disclosures on alignment with the Paris Agreement's objectives tend to be vague.
  
  
• NCAs can do more to guide FMPs. The ESAs observed that generally entity-level disclosures have improved since the 2022 report, but there remains significant variation in quality.  They found that FMPs are failing to refer to specific PAI indicators, for example, or explain how each indicator is considered. The ESAs note that NCAs could provide guidance to assist FMPs to better understand what is expected of them.  

Recommendations to the Commission

As part of the existing fundamental review of SFDR, the ESAs asked the Commission to consider:

•  Another proportionality threshold based on the size of an FMP's investments instead of the number of employees. The 500-employee threshold may not be a meaningful way to measure the effect of PAIs on sustainability factors. As an example of a "more suitable" approach, the ESAs suggest establishing a threshold based on the size of an FMP’s investments.
  
  
•  Whether the product-level disclosures under Article 7 SFDR should be disclosed on a "comply or explain" basis independently from whether FMPs consider PAIs on an entity-level under Article 4. This, the ESAs argue, would bring consistency between product-level and entity-level disclosures which cover all FMP investments and ESMA's Q&As in May 2023 which state that PAIs can be considered at product-level without also being considered at entity-level.
  
  
• Reducing the frequency of the ESAs' report on voluntary disclosure of PAIs to every two or three years. This is to allow the ESAs to collect and assess longer-term data more meaningfully.
  
  

Recommendations to the NCAs

In light of the survey data collected, the ESAs also directed some recommendations to the NCAs to help them take future supervisory actions, the key ones being for the NCAs to:

• Identify breaches and take enforcement action against non-compliant FMPs, if appropriate.
  
  
• Clarify market confusion between what it means to consider PAIs and take into account PAIs.
  
  
• Use the correct, technical terminology when considering principal adverse impacts, including: "sustainability impacts", "sustainability indicators", the "engagement policies to address the adverse impacts of the investment decisions", and the "degree of alignment with the objectives of the Paris Agreement", which are good measures of adverse impact, rather than using "ESG criteria", "ESG risks" and "sustainable investment goals", which are incorrect terms.

Firms which have opted out of considering PAIs may wish to review their existing website disclosures in light of the ESAs' recommendations.    

The ESAs' 2023 Report is by no means the last word on voluntary disclosure of PAIs; the ESAs have already announced their 2024 work programme on 4 October which includes the third annual report on voluntary reporting that will focus on specific PAI indicators and the mandatory reporting template.

However, more significant legislative changes, including possibly on PAIs, will ultimately be brought by the Commission once it concludes its review of SFDR. The consultation on this closes on 15 December, but no new rules are expected until after the new European Commission is in place at the end of 2024, so watch this space.

If you would like further information or assistance in understanding the ESAs' 2023 Report and its possible implications, please speak to your usual Travers Smith contact or any of the individuals below.